Are Interest Rates Really Heading Up?
When there is talk of rates going up, people and companies that are considering borrowing money tend to speed up their decision-making processes to lock in the lower rates. Investors who own a lot of bonds in their portfolios also get anxious because, when rates go up, the value of their bonds starts to go down.
The Federal Reserve, a.k.a. “the Fed,” has kept federal funds rates at zero for seven years now. But after a strong employment report from the Labor Department in November, citing that the economy has created 271,000 new jobs[i] the Fed may finally be ready to raise it. During those seven years, people paid an average of 15% on their credit cards[ii] and 4% on their 30-year mortgages[iii]. And today, a loan to buy a new car will cost you about 4%[iv]. So it was only the federal funds rate— the rate at which banks borrow reserves from other banks —that was at zero.
“Banks borrowing?” you may ask. “I thought banks just lent money!” They do both.
The Fed is where banks deposit their money. Those deposits, which are called reserves, are the means by which banks pay other banks. Before the financial crisis of 2007-08, banks did not earn interest on reserves, so they deposited what was required by law: $43 billion, plus another $1.9 billion in excess reserves.
Moreover, this $45 billion in total reserves was somehow able to circulate among banks and support trillions of dollars in payments. For example, say your bank is Wells Fargo, and you write a check for $2,500 to your car mechanic, who happens to bank at Citi. Wells deducts $2,500 from your checking account, and then transfers $2,500 from its reserve account at the Fed to Citi’s reserve account. Then Citi increases the mechanic’s checking account by $2,500.
No actual cash moves; it is all done electronically. However, in 2008, the healthier banks stopped lending their reserves to the failing banks, and the payment processing system was on the verge of collapse. To make sure people’s mortgage and car payments were processed, the government bailed out the failing banks. This gave the healthier banks the confidence they needed to lend failing banks reserves again. This prevented interruption of the payment processing system, which would have caused another Great Depression.
After the government stabilized the banks, the Fed embarked on a stimulus program (quantitative easing) through which it bought bonds from banks, which the Fed paid for by crediting the banks with reserves. The Fed bought so many bonds that reserves went from $45 billion in 2008 to $2.6 trillion today.[v] Historically, when the Fed wanted to raise rates, it would sell bonds to banks, which the banks would pay for with reserves. This drained reserves from the banking system, so the cost to borrow the remaining reserves would go up. Banks would then try to pass their higher borrowing costs onto their customers by charging them higher rates on mortgages, car loans, business loans, etc.
Today the Fed has a no way of draining those $2.5 trillion of excess reserves. So, to raise the federal funds rate, the Fed will now have to pay banks interest on those reserves. If not, there would be a stampede of banks wanting to lend out their excess to other banks and the Fed’s recently raised federal funds rate would fall back to zero. The Fed is not like your credit card company it does not set a rate and then require banks that need to borrow reserves to pay it. The Fed targets a fed funds rate and then it tries to hit that target by controlling the amount of reserves available for banks to borrow. In 2009, in anticipation of this dilemma, some members of the Fed discussed getting rid of all those excess reserves by selling the bonds back to the banks. However, instead of selling bonds, the Fed over the next few years bought trillions of dollars more.
The interest rate policy of the Federal Reserve, though, is but one variable in an economy full of variables. Plus, the only interest rate the Fed directly controls is the federal funds rate. So there is no guarantee that commercial banks will be able to pass their higher borrowing costs onto consumers and businesses—especially if the slowdown of the gross domestic product in the third quarter of FY 2015 continues. However, the Fed knows it must get the federal funds rates above zero. If the economy were to fall back into a recession and the rates were still at zero, the Fed’s only policy tool would be the unpopular bond-buying program, quantitative easing.
The Fed probably should have raised rates last year. Instead, what is likely now is that a slowing economy and tame inflation will put the Fed in the unenviable position of having to pay banks money to slow an already slowing economy and the interest rates you and I pay won’t change very much.
[ii] Dillworth Kelly “Average credit card interest rates rise to 15.07 percent” CreditCards.com, October 1, 2014, http://www.creditcards.com/credit-card-news/interest-rate-report-100114-up-2121.php
[iii] Federal Reserve Bank of St. Louis, https://research.stlouisfed.org/fred2/graph/?g=NUh
[v] Federal Reserve Bank of San Francisco, http://www.frbsf.org/education/publications/doctor-econ/2013/march/federal-reserve-interest-balances-reserves
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.